I work with entrepreneurs regularly who have raised or plan to raise money from a friend or a family member. While this seems like an easy path to fueling your startup, taking friends and family money can lead to significant difficulty.
– Ann Voskamp
Raising funds from friends and family can and often does result in unexpected problems and complications. These include strong reactions when money is lost, wanting a role in the business, frequent questions on progress, and unsolicited advice. All from an inexperienced and unsophisticated investor.
Raising Friends and Family Funds
I coach entrepreneurs to do everything possible to avoid depending 0n friends and family money to fuel their startups. That said, if you are in a position where raising funds from experienced investors is unlikely, friends and family money may be your only option to continue building the business.
Ask yourself this one question: “If professionals are unwilling to lend money or invest, how can I expect friends or family to lend money or invest?”
Friends, Family, and Fools
There's good reason why investors jokingly refer to friends and family money as the “Three F's” – Friends, Family, and Fools.
No matter how optimistic you are of your prospects for success, the likeliest outcomes fall short of your dreams and your friend's or family member's expectations. Their investment in you and your company or loan to you is likely to evaporate.
Linking friends and family member relationships with your business success seldom works out well.
Even against this backdrop, friends and family money can have a place in fueling your startup. If you must raise funds this way, do it as well as possible. I put together 7 common pitfalls to avoid when raising 3F's money.
7 Common Pitfalls to Avoid:
- Skipping Written Documentation. Everything must be in writing. Everything. Treat friends and family money as if it were a bank loan or a professional investment. Good documentation protects both you and your friend or family member. Well documented terms reduce the likelihood of unreasonable expectations.
- Skirting the “Loan or Investment” Question. Lack of clarity here will typically lead friends and family members to think of their money as an investment when things go well and as a loan when the business is failing. When this happens, they will have expectations of ownership or demand their money back. Perceptions of even a small ownership stake can cause problems when the time comes to raise funds from professional investors. The same is true of loan expectations when you need to borrow money from a lending institution.
- Neglecting a Repayment Schedule. If the money you receive from friends and family is a loan, make it clear that the loan will be paid back within a specific time frame. Provide your lender with a timeline that provides a final deadline for total repayment. Also document the schedule for making regular payments. Your loan may be paid back through a series of payments or a balloon payment a few years down the road. Either way, be specific and clear how repayment is to occur. Without a schedule and deadline, repaying the loan defaults to your last priority.
- Disregarding Risks. It is easy to believe that your business is going to be the next Facebook or Google. It is equally easy to make statements and promises of significant returns. Not only can the promising statements get you into trouble, but also creating the perception of a “sure thing” or low risk will only increase the negative reactions should your business not meet those expectations. Be as clear as possible what you understand the risks to be.
- Setting Interest Rates Below Market. It is tempting, particularly with family funds, to set the interest rate at zero or significantly lower than market rates. Below market rates might cause avoidable tax problems (consult a tax professional here, I am not one). It also contributes to the perception that the loan can be taken less seriously. Instead, set a rate close to what the best of borrowers would get in today’s environment.
- Forgetting to Consult Professionals. You must involve tax and legal professionals in every financial transaction for your business. Utilize professionals to prepare all documents or review and correct all self-prepared paperwork. Any money spent in legal fees during an investment or loan transaction should be thought of as insurance potentially reducing future legal fees.
- Ignoring Your Balance Sheet. Friends and family funds can be forgotten when it comes to accounting for them. When you are raising funds in the future, it could be a deal killer. For example, when due diligence reveals a previously undisclosed loan or investor, any interest from professional investors will fade. Investors will have a clear reason to not trust you, and recovering from that lost trust is nearly impossible. Another downside is that your balance sheet does not reflect the real financial conditions and obligations of your company. Make sure any friends and family money is properly accounted for, whether a loan or an investment.
Free PDF for You
Friends and family money will amplify any existing stress points. It always comes with emotional baggage. If your business falters, the money taken from friends and family could adversely impact friendships and family dynamics for your lifetime.
Oh, and one last thing to AVOID… family reunions, weddings or any other event with friends and family IF you lose their investment or fail to pay the money back!
What's Your Experience with Friends and Family Funds?
If you've raised or borrowed funds from friends and family, what have you learned? You likely have real insights and good advice based on your experiences. Please leave a comment below and help your fellow entrepreneurs learn!
Old Key photo credit: Brenda Clarke, via Flikr: https://www.flickr.com/photos/37753256@N08/